Credit­-default swaps

A credit default swap is an insurance policy against the risk that a bond defaults-- that is, that a payment is not made.

Imagine you run a large pension fund. Among your holdings, you have $100 million in Walmart bonds. The risk that Walmart isn't going to make a payment on their bonds is extremely small but not zero. If that very unlikely event happened, though, your pension fund would take a major hit. To hedge against that, you'd buy a credit default swap-- you'd pay a small fee (likely an upfront fee and a periodic fee) to the seller of the swap. In return, if Walmart defaulted on their bonds, the seller would make the pension fund whole.

If the market consensus is that there is a 0.1% chance that Walmart defaults, the fair value of a credit default swap on $100 million in bonds would be $100,000 (I'm doing a whole lot of hand-waving here-- in reality you'd have lots of different bonds with different durations and different default risks, even if the bonds default, bondholders might recover some value in bankruptcy so you likely wouldn't use a full $100 million payout, and there will be spreads so you wouldn't buy at the theoretical fair value). If you're a hedge fund that believes that the real risk is much higher, you can buy a $100 million credit-default swap for $100,000 without owning any underlying bonds. If the market consensus changes to now believe that there is a 10% chance that Walmart defaults, that swap is now worth $10 million (again, handwavy math) and you've made 10,000% profit if you sell those swaps to the unhedged pension funds that are now in a panic that their bond holdings are going to tank.

I've seen various articles on the Ackman trade @BobBaeker referenced. They all talk about it being some sort of derivative but I've not seen any that specifically called it a credit default swap. My guess is that Ackman was trading a different but similar derivative. Credit default swaps entered the lexicon during the 2008 financial crisis so articles usually name them specifically if that's what was involved. Other derivatives aren't as commonly known so I'd guess that "credit protection on investment-grade and high-yield bond indexes" refers to something other than a credit default swap.